Varied Outlook for AREITs

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-Opportunity highlighted in Sydney, Melbourne office
-MS preference lies in US exposure, office segment
-Settlement risk on residential not alarming
-Subdued retail segment expected to continue
 

By Eva Brocklehurst

The outlook for Australian Real Estate Investment Trusts (AREITs) is mixed, with falling rents in some segments reflecting softer economic conditions and a subdued outlook. Overall, the sector has had a strong start to the year and Morgan Stanley believes the drivers of outperformance remain intact, including a low interest rate environment, and a high degree of earnings certainty coupled with relatively attractive growth.

A global outlook report from TH Real Estate suggests US market conditions are supporting a solid performance in the commercial real estate sector, while there remains some potential for marginal growth in Europe. For the Asia-Pacific region the outlook is subdued. The analysts suggest asset pricing has risen to near record highs in the region but corporate and household sentiment has been affected by volatile financial markets and incrementally tighter US monetary policy.

The firm's Asia-Pacific analyst suggests conditions in prime retail and residential markets have worsened in Hong Kong and Singapore while opportunities exist in Tokyo and the Sydney grade B office sectors as well as those segments considered uniquely defensive, such as office and retail in Sydney, Melbourne and Tokyo.

Morgan Stanley re-positions its order of preference, favouring those with a global growth exposure such as Goodman Group ((GMG)) and Westfield ((WFD)) . The view on these two stocks is based on their exposure to US expansion, development completions and urban renewal.

As a whole, the broker believes the industry can continue to outperform and the sector is reasonable value given its historically wide spread to bond yields, but a lower inflationary environment is expected to affect growth over the medium term. Credit conditions are likely to tighten, highlighted by widening spreads. This presents the main risk to the broker's view: if there is a material tightening in credit conditions and a recovery in Australian industrial earnings growth.

Morgan Stanley retains a preference for office AREITs over retail, resuming coverage of Dexus Property ((DXS)) and Investa Office ((IOF)) with an Overweight rating. This preference is driven by a tightening Sydney office market, driving 12% effective rental growth in 2016 and 2017 and a recovery in comparable net operating income growth.

The broker downgrades GPT Group ((GPT)) to Underweight, on valuation. The stock is still appreciated for its defensiveness but better value is envisaged elsewhere in the sector. Mirvac Group ((MGR)) is upgraded to Overweight as the broker remains tactically positive on residential exposure and the company also has an overweight exposure to the Sydney office market.

Morgan Stanley believes house prices are the key metric for residential AREITs, and inputs such as clearance rates, building approvals and interest rates are supportive of house price growth or, at the very least, stabilisation. The broker suspects the market has become too negative on residential exposure on perceived settlement risk.

Macquarie also observes settlement risk has been a topic of discussion regarding both Mirvac and Lend Lease ((LLC)). This follows a tightening of credit standards across the mortgage market, and the emergence of a lack of liquidity for buyers to settle. The broker's checks have revealed some banks are no longer lending to foreign investors.

Importantly, settlements are still occurring. Analysing 26 projects across the sales pipeline for the two companies, the broker identifies some projects in the Docklands region of Melbourne and Brisbane's inner city as being at most risk of default as a result of a depreciation in asset values since the pre-sale date.

The oversupply of stock in the two states is not stretched but annualised 12-month unit approvals are running at 67% for Queensland and 40% for Victoria above respective 10-year averages. Macquarie expects this to exert downward pressure on pricing.

Although not completely confident until the money rolls in, and noting there are no guarantees all buyers will settle, the broker suspects there is compensation for this risk implied in the current share prices, reiterating an Outperform rating for both Lend Lease and Mirvac.

In the retail sector, international names continue to underpin development activity with stores Zara, H&M and Uniqlo taking share from the rest of the shopping centre tenant base. Macquarie observes, given continued store roll-out, that this group's market share will increase to around 2% next year. With around 30% of a regional mall's income typically derived from apparel retailing, the broker also estimates this will place downward pressure on the performances of these shopping centres.

Macquarie is concerned about the impact of international retailers in Australia, as their low price points mean domestic competitors cannot raise their prices to offset the cost impact of a lower Australian dollar. International retailers are generally underpinning most retail shopping centre developments in Australia.

The broker also believes these stores are typically less lucrative for landlords and lower rents suggest initial yields on developments are only slightly above the cap rate – the ratio of asset value to producing income – for many centres. The broker expects the impact of international retailers, a reduction in underlying sales growth in line with slowing population growth and moderation in the housing market will provide headwinds for the retail segment.

Macquarie retains Underperform recommendations for Scentre Group ((SCG)) and Vicinity Centres ((VCX)). The broker's preference among the A-REITs remains with Westfield, Goodman, Mirvac, Lend Lease, Dexus Property and Charter Hall ((CHC)).
 

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